Working Capital: Benefits of the Money Market

March 14, 2010 Leave a comment

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:

Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja

Capital Structure: Optimal Composition

March 7, 2010 Leave a comment

The Bigger Picture:

To start our discussion on how do companies decide on their composition of capital structure, it would be beneficial to take a step backwards, and glance at the bigger picture; prior to jumping into the details. Any company is brought into existence to increase the wealth of its owners; the shareholders. The company does so by generating economic returns through the process of taking “financial capital and [converting it] into assets…[to fulfill] customer needs” (Groth and Anderson, 1997). The financial capital utilized by the company, which becomes its assets, comes from shareholders’ funds (equity) and debt. It is the different percentage claims of the financiers (shareholders and debtors) that make up the capital structure of a company.

As companies are established to increase shareholder’s wealth, managers want to put in place a capital structure to achieve just that. Thus an “efficient mixture of capital reduces the price of capital … [and in doing so] increases net economic returns which, ultimately, increases firm value” (Groth and Anderson, 1997).

But reducing the price of capital is not the only task a company faces as it increase the wealth of its shareholders. A company face other variables such as:

-> Government taxes on the revenue it generates
-> Indirect bankruptcy claim costs, rendered through “higher interest rates” (Ross et al., 2008, p. 463), should the company default on its debts.
So, in selecting a capital structure, taxes and bankruptcy claims must also be taken into consideration; along with reduction of capital costs. Given such qualitative framework, the following questions arise: Is there an optimal capital structure for companies? Is a company’s capital structure a result of its operating context, or underlying principles?
In Principle:

Each company does have an optimal capital structure; and such structure is a result of underlying principles.

As stated briefly, four parties have claims over a company’s earnings: the shareholders (equity), the bondholders (which shall represent the debt portion), the government (taxes), and bankruptcy claims (indirect costs). As companies cannot influence directly the claims of the latter two [taxes and bankruptcy claims], it must do so by optimizing the debt-to-equity mix. “Stockholders choose the debt level to maximize the value of their equity taking into account the cost of default” (Harris and Raviv, 1990).

Modigliani-Miller (1958) have proved that the “value of [a] firm is completely independent of [its] capital structure” in the absence of taxes and bankruptcy costs. It was later demonstrated that “high leverage capital structures” (Miller, 1988) reduce corporate income taxes, as accounting principles require interest expense to be subtracted from earnings prior to tax calculation. With higher leverage [debt] capital structure, more money ‘in theory’ finds its way to shareholders/bondholders; since less of it goes to taxes. But one side effect of increased leverage is the increased risk of bankruptcy. Thus as a company’s leverage increases, so does its bankruptcy claims costs; which is reflected through increased interest rates on debts. With the increase of bankruptcy claims due to higher leverage, less money finds its way to shareholders/bondholders.

So in principal, the optimal capital structure of a company is when the tax shelter gains minus the bankruptcy claims costs is maximized. This should bring about the most wealth to the shareholder’s of the company. Effectively, “the use of the right amount of debt lowers the companies weighted cost of capital” (Groth and Anderson, 1997).

In Reality:

Though the above explanation of how to decide on an optimal capital structure makes perfect sense, it is all academia. “No equation exists to determine the optimal capital structure for a company” (Groth and Anderson, 1997). The actual market environment is much more complex to capture in mathematical formulas. Some factors that make it difficult to arrive to an optimal capital structure include (the list is not exhaustive):

-> “Investors’ receptivity to debt” (Milken, 2009): This is mainly influenced by the current market conditions.
-> A culture’s acceptability of debt: Culture plays a big role in “influences our values, which in turn affects our attitudes, and then behavior” (Chui et al., 2002).
-> Country factors: “Aggarwal (1981) [analyzed the] 500 largest European firms” (Chui et al., 2002) and concluded that country factors play a role when companies decide on their capital structure.
-> Free cash flow problem: Whereby if a company generates a lot of cash flows from the optimal capital structure, it would “waste it rather than pay it out to investors” (Myers, 1993) considering that a conflict of interest would be present between management and shareholders.
-> Deviation from industry norm issues: If a company structures its capital in a way where it deviates substantially from its industry norm, it might be frowned upon by lenders, making it difficult for the company to attain debt-financing.

Closing Notes:
Given the complexities of capturing all the variables that effect the optimal capital structure formula, then the capital structure composition is left to an educated guess at best: industry standards, operating context of the firm, stakeholder’s preference, etc. But as companies experiment with various capital structures, they would be inching ever closer or further to the optimal point. One statement that rings true, regardless of capital structure composition, is “it doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will” (Milken, 2009).
~ Youssef Aboul-Naja

Capital Budgeting, Real Options, & Bending Grass

February 28, 2010 3 comments

Trees, no matter how well rooted they are, topple over from gusts of winds due to their inflexibility. But Confucius noted that “when the wind blows, the grass bends”. Thus, adaptability to the surrounding environment, plays a big role in survival. Against such backdrop, do I put into perspective the topic of Real Options; and how that aids management in better project selection; making them more adaptable.

Companies are established to generate wealth to its stakeholders. In doing so, a company must be working towards a vision; which is synonymous to the company’s central theme. By working towards their vision, companies take on and execute various projects. But since a company’s main object is to maximize the wealth of its stakeholders, management must have a way [or a tool] to help them select the most profitable projects. This is where Capital Budgeting comes into play.

In a nutshell, capital budgeting is the process of “making and managing expenditures on long-lived assets” (Ross et. al, 2008, p.2). Management must determine the cash inflows and outflows of a given project to determine its suitability relative to:

  • How the cash flows affect the stakeholders’ overall wealth
  • How the cash flows measure against the cash flows of other potential projects that management could undertake instead

Given that companies have limited funds (or fund sources), management must select those projects that create the most financial benefit to the shareholders.

But the process of selecting projects is not as trivial as portrayed above. A company exists in a complex environment, whereby a lot of factors are interconnected and in play. In fact, market environments are so complex, that they are semi-deterministic; they cannot be modeled with 100% accuracy, yet they are not chaotic. Thus uncertainty complicates the project selection process, as future cash inflows and outflows are only known with a given degree of accuracy.

In solving the project selection problem, various investment decision tools have been devised to assist managers; most prominent of which are:

  • Net Present Value (NPV): whereby the future cash inflows and outflows are discounted back to present money and all added up. The project with the highest NPV value will be the clear winner, as it maximizes shareholder’s wealth.
  • Internal Rate of Return (IRR): the IRR is the rate were a project does not contribute any gains or losses to the shareholders’ wealth – thus management would be indifferent about executing it. With this tool, managers compare the rate of return of a given project against its IRR to determine its level of profitability. The project that produces that highest profitability is selected.
  • Payback Period: Projects are determined on how quickly the cash inflows payback the initial investment [cash outflow]. The fastest project is selected.

Though this is by no means an exhaustive list, each method has its short comings. These methods were “designed for relatively stable environments… As a result, business strategy … turn out to be flawed because something outside their control doesn’t go as planned” (Trigeorgis et al., 2007). What was need is another method, that accounts for uncertainty and management’s ability to respond to future events; thus the method of Real Options came about.

“At its core, the real option perspective is like other theories of investment in that it is concerned with identifying the factors that influence the investor’s threshold —the point at which investors choose whether to invest or not” (Miller and Flota, 2002). What the real options method did differently, is that it introduced the concept of “the possibility of contingent decisions” (Amram and Kulatilaka, 1999). The method was a bit more chaotic compared to other methods, in the sense that it was more reflective of reality. Thus it accounted for situations of project expansion, contraction, abandonment, timing of events, and “sequential [growth] options [of other projects]” (Wyant, 2009). By explicitly accounting for the future flexibility inherent in capital investment opportunities, the real option method would better portray the real financial effect of a given project on shareholders’ wealth.

The main benefits of the real options method is that it facilities for better planning and in taking strategic decisions. Other methods might be too conservative in analyzing the benefits of a project, which would result in its rejection. The reason why the other methods suffer from such consevatism, is because they commit project decisions at the beginning stages, which results in “sacrificing flexibility and increasing exposure to … uncertainties of new markets” (Miller and Flota, 2002). Therefore with the real options method, better strategic modeling is conducted, which results in flexible project variability, a more informed management and lower costs [cash flows].

At my current place of employment, a financial leasing company, we constantly use the real options method. Since our funds are limited, we are selective with the clients we are willing to finance. In determining the risk profile of the client, we attach probabilities to our future relationship directions with the client: increase/decrease/or cap the exposure, perform repossession in the event of a payment defaults, file a lawsuit, etc. Based on such analysis, we are able “to better quantify the value of each contingency” (Trigeorgis et al., 2007) and effectively better handle our client base and overall company risk and returns.

~ Youssef Aboul-Naja

Why do companies need to understand risk?

February 22, 2010 2 comments

“If you have a pilot flying a plane who doesn’t understand there can be storms, what is going to happen?” (Nocera, 2009). Against this backdrop, I commence my discussion regarding the importance of understanding the nature of risk, and its profound effect on the returns of long and short term investments undertaken by businesses. The thought of escaping risk is an impossible feat. As with every action, there is an attached element of risk to it; ‘avoiding risk can itself be risky’ (Salzberg, 2010). Effectively, to survive and achieve growth, a business must learn to embrace risk by understanding its intricate elements, and the impact it brings about its operations. Thus risk, if handled properly, may very well be a source of opportunity. The Chinese captured such a concept, by denoting the symbol for risk as “a combination of two symbols—one for danger and one for opportunity (Damodaran, 2005).

What is risk? Though there is no verdict on an exact definition, Elroy Dimson proposed a rather interesting version, which states that “risk means more things can happen than will happen” (Farrell, 2007). So in that sense, risk is the anticipation of future events that will have an adversary effect on a given business; though not all events will take place. Also, not all events can be anticipated. If we can foretell the future, the element of risk would simply diminish to zero. Thus, risk is our interpretation of how the future events will unfold, given the current factors we have at hand.

From an Investment’s point of view, taking on risk will result in some form of return. How high or low the return is depends on how the predicted risk element pans out with the actual future events. Nonetheless, a return is composed of two elements: an expected part and a ‘surprise’ (Ross et. al, 2008, p.322) part. The expected part further breaks into a:
– Systematic element: a surprise element that is applicable to almost every asset
– Unsystematic element: a surprise element applicable only to a single asset

As companies go about their everyday business, they constantly engage with various activities; each having an element of risk. And as discussed earlier, each risk has a return associated to it. Thus, as companies go about their daily business, they are maintaining a portfolio of returns:
-> They must achieve a certain return to shareholders
-> They might have invested in other companies (thus they expect a certain return)
-> They might be undertaking a project (thus they need to achieve a certain return margin for the project to be profitable)
So for companies to survive, they must understand risk (the systematic and unsystematic elements), as this affects the returns generated, and would, in turn, affect the company’s return/investment portfolio on the short and long runs.

In understanding systematic risk, I bring upon an example from the company I currently work for. I work in a financing house in Saudi Arabia. Though it is a privately held company, they are constantly engaged in loan extending transactions, which bears an element of risk. The rates that are offered to the clients’ partly accounts for the systematic risk element [though it cannot be predicted precisely]. Examples include:
-> The prevailing SIBOR in the Kingdom
-> The death of King Fahd in 2005: “the market opened at a decline” (Akeel, 2005), which resonated across the whole Saudi economy, resulting in our company receiving delayed payments from its clients, and a lower overall return.
-> During the end of 2008 and throughout 2009, bearing in mind the global crisis, the oil prices fluctuated from “$98 per barrel, rose to $147 per barrel in July, then ended the year at $44 per barrel” (Anon, 2010). Such swings had an effect on government spending (especially in the early part of 2009), and effectively also affected client payments to our company.

Now, in understanding unsystematic risk, we continue upon the example of my company. Unsystematic risk examples include:
-> The change of our General Manager – the older one suddenly decided to resign. As the new GM is not tested [came from outside], this raised the risk factor to the company’s owners, thus requiring higher returns (meaning a higher cost of capital on our company) [short-term issue]
-> Changes in the leasing laws, as per directions from the Saudi Arabian Monetary Agency. This drove up the cost of doing certain parts of our business [short-term issue]
-> A conflict of interest issue, which required us to create two operational units (instead of one), and essentially drove the prices up [long-term issue]

Thus, in order to continue surviving, the company must understand how these systematic/unsystematic risks affect it – whether they are long or short term in nature. Once it understands, it will be able to minimize its risks [i.e. maximize its returns]. Also, by understanding how the various risks impacting the company and its effect on its overall returns [from current projects], they will be able to determine whether or not to “add a new project to its existing portfolio… [By] estimating the coefficient of correlation between the cash flows [returns] from the new project and the total cash flows [returns] from existing projects … it can [thus] determine the effect of the new project on the means and standard deviations of the total cash flows” (Hull, 1986) and decide on its overall benefit to the portfolio.

Understanding how risk [its systematic and unsystematic elements] impacts a company’s activities is of crucial importance to its survival in the short/long term. Failing to comprehend and incorporate such risk elements in business activity will lead to catastrophic results. Referring to the 2008/2009 global economic meltdown would suffice.

~ Youssef Aboul-Naja

Which Wealth should Corporations Maximize?

February 9, 2010 2 comments

In the sixteen hundreds, John Donne wrote his Meditation XVII poem, which included the ever infamous line of “no man is an island”. If I may draw similarities between corporations and individuals, given their environmental complexities, then one may adapt Donne’s line to: no corporation is an island. A corporation is set up by pooling resources of investors, known as shareholders, in order to create for them more wealth. But “money on its own produces nothing … it is only in combination with human, and at times, physical capital that a corporation comes alive” (Simpson, p.2). When Johnson & Johnson’s former CEO, Ralph Larsen, was asked “Do you serve shareholders, or do you serve stakeholders?” (Simpson, p.2), his reply was both; which emphasizes the fact that in order to create additional wealth for the shareholders, a corporation must keep a keen eye on the needs of the various stakeholders. But given the inescapable economic problem of scarcity, what should the corporate objective be? Maximizing the wealth of the shareholders, or that of the stakeholders?

When I was a young kid, my father once took me for a paddle boat ride at the lake. I wanted to take charge of the boat, by controlling the navigation rod; to which my father gladly agreed. The boat was drifting aimlessly, and all our paddling effort was going to waste; I was navigating, paddling, talking to my sister and feeding the ducks. It is when my father told me to focus on navigating, and aim for the far mountain, that the boat went in a straight line.

Using that story in the corporate world, we notice that by maximizing stakeholder wealth, a company must satisfy various constituencies [employees, suppliers, environment, communities, etc.], that the overall wealth-creation effect is dampened. There is no clear focus on how to chose amongst the various stakeholders; and what constitutes them in the first place. Yet, we must not forget that shareholders are also stakeholders. As a matter of fact, by corporations maximizing shareholder value, they are in effect also maximizing total stakeholder value. The reason is that shareholders only have claims to the “residual cash flows” (Sundaram); after all the stakeholders have been paid. Thus, by catering to the final link in the chain, the shareholders, all the other links would also been catered to in the process, resulting in the maximum wealth creation for all parties.

The above shareholder theory logic, have been contested by the stakeholder theory advocates, stating that, since Aristotle’s times, it has been known that “if you want to maximize a particular thing … you should perhaps not try to do it consciously … in a complex world, order [always] emerges” (Freeman, p.367). Thus their claim is that, by focusing on the stakeholders, the shareholder’s wealth will be maximized as a by-product.

In my opinion, such view is invalid, given that stakeholders are only interested in so far as getting their own benefits; why must a corporation engage in further risk after they [the stakeholders] get their cash flow? Entities are motivated only when “satisfiers (factors that cause satisfaction)” (Kotler and Keller, p.203) are present; as explained by Fredrick Herzberg. Thus given that shareholder wealth creation comes after that of the stakeholder, then the stakeholder rebuttal must be necessarily false. Stakeholder theory “politicizes the corporation” (Jensen, p.237), adding complexity to better defining a company goal; while shareholder theory, the goal is “single-valued metric … observable and measurable” (Sundaram, p.355).

Another argument that is often used against shareholder theory, is that such narrow view of wealth maximization will lead to greed, and eventually create value loss for stakeholders; one needs to look no further than the not so-long-ago corporate scandals such as Enron, Tyco and Worldcom. It should be understood that these scandals were a result of individuals trying to benefit themselves, regardless of which theory management has subscribed to. The individuals were playing outside the “rules of the game”; as Milton Friedman calls it. Enron’s CFO, Andrew Fastow, admitted to that; “I … engaged in schemes to enrich myself and others at the expense of Enron’s shareholders” (Sundaram and Inkpen).

At the end of the day, both shareholder and stakeholder theory “seek a path to a promised land in which accountable corporations managed by ethical decision makers create the greatest value for the greatest number of stakeholders” (Sundaram and Inkpen). There is an Arabic saying, that goes along the lines of: ‘the boat that does not have anything for God, will sink’; in that respect, the company’s main objective is to maximize shareholder wealth, while taking at a secondary level the requirements of the environment it engages with – the stakeholders.

~ Youssef Aboul-Naja

On Marketing:: Research & Consumer Satisfaction

January 24, 2010 2 comments

“… especially in today’s idea-based, design-obsessed economy … innovation calls for variation, failure, and serendipity” (Hindo). Our lives, as humans, may be categorized as a collection of needs. Though each individual’s needs are unique in their own respect, whether be it in time or essence, they do bare traits of resembles with the needs of the 6.8 billion people on this planet. Abraham Maslow, in his 1943 hierarchy of needs theory, stated that a human need can be classified in one of five categories; each addressing defined, non-overlapping, human necessities. What marketers spend most of their time doing, is influencing consumer wants, which are “specific objects that might satisfy the [preexisting] needs” (Kotler and Keller, p.52). The more compelling the influencing is, the more successful the marketing campaign, and underlying product/service. Given the myriad marketing campaigns that consumers get bombarded with on daily basis, an exceptional marketing campaign must be truly innovative to standout and demand attention. Professor Stephen Brown of Ulster University states that spending too much time on research and consumer satisfaction during marketing will kill innovation; there needs to be an element of surprise or inventiveness. “Research can be very helpful in deciding what to do, but not in determining how to do it” (Foltz)

Examples are abound of companies that push the innovation envelope; whether be it with their products/services, or marketing campaigns. Google, Apple, Nike and Whirlpool are but a few firms that define their domain. These companies are on an everlasting marketing crusade, to tap into the emotional psyche of consumers, to justify their product offering. Doing so requires knowledge of consumer needs coupled with innovation. Marketers want to instill in the minds of consumers that the marketed products/services provide the highest possible value; thus being the logical choice when consumers rationalize which product/service to select. Satoru Iwata, the president of Nintendo, defined the innovative spirit best when describing how their company have set themselves apart “with imaginative games” (Levine) and redefined gamer interaction. Capitalizing on that, through marketing, have placed Nintendo in the number one spot of Businessweek’s World’s Best Companies for 2009.

Though, let’s not forget that “finding that Holy Grail of marketing, the ‘unmet need’ of a consumer, remains elusive. You need time, just thinking time, to step out of the day to day to see what’s going on in the world and what’s going on with your customers” (businessweek). As important as innovation is, if consumer relevance is not present in the marketing, the underlying product/service will be a failure. At the end of the day, the marketing efforts are but a handshake gesture extended to the consumer in meeting their needs; it must provide them with value in order to be accepted. Understanding the consumer will effectively mean researching and satisfying the market segment that is being targeted. When Nokia wanted to position itself as the leader of low-cost mobile phones in the emerging markets [China, India, etc.], they needed to understand how “illiterate people live in a world full of numbers and letters” (businessweek); and thats how their all-iconic interface, made up of only images, was born. When companies put a sincere effort in understanding what their customers want, they will be able to trigger their satisfiers [factors causing satisfaction – as Frederick Herzberg defines them], and ultimately stimulate sales.

Where does this make us stand on the issue of research and consumer satisfaction in regards to marketing: does it kill or stimulate innovation? It is a universal law, that anything used in excess, will do more harm than good. Research and consumer satisfaction will deliver products and services that are more relevant to the consumer needs. On the other hand, progress is only brought about by exploring unchartered territories through offering and marketing new products/services. This is what ultimately defines a given product’s/service’s points-of-difference; seperating it from other competing offerings. Marketers must finely balance their innovation efforts, as they are curving their market-share slice.

~ Youssef Aboul-Naja

Is ad pre-testing a waste of money?

January 19, 2010 3 comments

Is ad pre-testing a waste of money? I don’t think it is. Books get reviewed before being published and movies are pre-screened before their release; so why shouldn’t advertisements be pre-tested? The costs of the testing come at a fraction of the actual ad costs; and the benefits are well worth it, as pre-testing aids in generating “relevant attention” (McKee, 2008). As a matter of fact, with relevant ads, companies end up benefiting in the long-term, as “less media money [is needed] to be spent on achieving frequency and more available for increasing reach, since cut-through occurs faster” (Agee).

In today’s technologically connected world, companies must be especially careful with their advertising. Although a company might be releasing an advertisement for a specific region, its reach could become global, via web technologies {youtube, facebook, blogs, etc} – especially with ads that generate reactions at the extremes: if an ad is brilliant or horrible. So, with the help of pre-testing, companies increase their chances of outputting brilliant ads, all the while steering away from potential pitfall.

We shall also not forget that the non-technical world is also connected, as a by-product of globalization; products/services are constantly crossing borders. Pre-testing becomes especially important, as a successful ad in one country, could have a whole different meaning in another. There is a story that goes along the lines of a cola company placing an ad in the Middle East made up of two adjacent pictures: the first is of a man lying in the dessert exhausted from the heat, the second is the man all refreshed after drinking the cola. Though the ad was successful in the West, it was a complete failure in the Middle East, as Arabs read from right-to-left (thus the message they understood was: if you drink the cola, you will die). “Ad testing [serves] to sniff out potential pitfalls in the ad” (Sara), increasing the ad’s potential to be as effective as possible.

“The new currency is measuring engagement” (Businessweek); the more an advertisement has an “emotional impact” (Walid), the higher the chances of converting the advertising costs to consumer purchases. Thus pre-testing plays a crucial role:

  • In the early life stages of a product/service; as no connection exist with the customer
  • With creative or controversial ads; as consumer’s reaction is unknown.

Some companies claim that pre-testing can’t predict the real-world, as the testers usually “select the strategy that is less differentiated..[thinking they are being critical] as they munch on nachos … on a Sunday afternoon” (McKee, 2007); effectively killing ad creativity. Countless examples are raised of how some ads failed pre-testing, yet were extremely successful with consumers.

Although the science of pre-testing is still imperfect, but the solution is not to stop it altogether; we must remember that countless other examples also exist on the flip side of the coin: brands saved from bad advertisement at the pre-testing phase. As technologies advance, testing methods are becoming much more accurate. Also, companies are increasing the size of the test groups in creative ways, yielding more accurate results; for example, Google has done so by taking user-generated video entries when creating their Gmail commercial (Google’s email solution). Pre-testing should be used as a “compass … to explore … and not [like] a map” (McKee, 2007).

~ Youssef Aboul-Naja